As chairman of the US Federal Reserve, Alan Greenspan had cultivated a style of speaking a lot, without communicating what his intentions were — in fact, interpreting Greenspan’s statements had become a minor specialisation amongst Wall Street economists. Incidentally, heads of other central banks have also learnt from Greenspan, as manifest in the following headlines in the Indian press, both reporting on the same speech by Dr Reddy:

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The term liquidity has now become a puzzle and an irritant for many. Mr David Longworth, Deputy Governor of the Bank of Canada, has given a wonderful speech on the subject. He says there are 3 kinds of liquidity:

Macroeconomic liquidity, which has to do with “overall monetary conditions,” including interest rates, credit conditions, and the growth of monetary and credit aggregates.

Market liquidity, which refers to how readily one can buy or sell a financial asset without causing a significant movement in its price.

Balance sheet liquidity, which refers broadly to the cash-like assets on the balance sheet of a firm (or household). For non-financial firms, balance sheet liquidity is often measured by the short-term liquid assets on their balance sheet. For banks, which must manage their liquidity very closely, balance sheet liquidity is reflected in a detailed breakdown, by maturity, of their assets and liabilities – especially those coming due in the short term. The ability of banks to fund themselves is often referred to as funding liquidity.

The common element in these concepts is that liquidity is the ability to obtain cash – either by turning assets into cash on short notice or by having access to credit.He focuses on the first two. How to measure the two?

The key indicators of macroeconomic liquidity, in terms of price, are the policy interest rates and the term structure of interest rates paid by borrowers. In terms of quantity, the key indicators are the growth of monetary and credit aggregates and the state of credit conditions more generally. In normal times, central bankers tend to place more emphasis on interest rates than on monetary and credit measures.

So, the liquidity which is managed by central bankers is macroeco liquidity.

Market liquidity refers to the extent to which one is able to quickly and easily buy and sell financial assets in the market, without moving the price. Market liquidity captures the aspects of immediacy, breadth, depth, and resiliency in markets. Immediacy refers to the speed with which a trade of a given size and cost can be completed. Breadth, often measured by the bid/ask spread, refers to the costs of providing liquidity. Depth refers to the maximum size of a trade for any given bid/ask spread. Resiliency refers to how quickly prices revert to fundamental values after a large transaction.

That is pretty well said. J

Hence, market liquidity has number of aspects and each one matters equally.There may be depth and breadth in the markets but there could be times when immediacy and resiliency may not occur, as it was the case in sub-prime crisis.

Generally speaking, the more liquid the market, the better. But there is an important caveat – if market participants come to expect that market liquidity will always be ample, and they acquire assets with the assumption that they can liquidate their positions quickly and at fairly predictable prices, they may end up taking on more risk than has been factored into the purchase price. And this could sow the seeds of a nasty correction in the event of a shock and a rapid decline in market liquidity. That said, liquidity is the lifeblood of markets.

Both forms of liquidity have been increasing over the years. Macroeco liquidity because of low interest rates world over. And what keeps interest rates low- high savings by emerging markets.Market liquidity has been low as bid-ask spreads have been low and low volatility in all aspects of financial markets.

Longworth adds it is because of new instruments, new players (hedge funds etc) and advances in tech that are responsible. He also suggests that Great Moderation and Globalisation are also important factors for increasing market liquidity. Then he looks at how liquidity played a role in recent crisis and Canada’s response to the same.

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This topic is being widely researched and debated worldwide. As populations age in developed world what is likely to happen is the question which interests all. So all experts from various fields – public finance, financial markets, labour etc are looking at how ageing would impact their areas of specialization.

Reading each one is desired but takes time and effort to comprehend. Jean Claude Trichet helps a lot by doing a literature survey on the same in his recent speech and it is a very useful one. Let me quickly summarise the findings.

First, People ageing is a natural phenomenon then why is it a concern? So far, the ratios of young and old in the population has been stable and favored the young. So as a result, you have a larger young population. Now the problem is because of low fertility rates and longevity increasing due to medical care, slowly there is larger % of population in the old age, usually referred to as 60 years and above. This would have wide changes but it would be only over a period of time.

Impact on Savings: As majority of the people age, the idea is that they would need more savings to finance their expenditure in the old age.

One of the main tenets of the life-cycle theory is that individuals try to smooth consumption over their lifetime. As income tends to be relatively lower when individuals are either very young or retired, their savings typically follow a hump-shaped pattern, with a higher savings rate during their working life. For a given retirement age, population ageing increases the proportion of households with a relatively lower savings rate in the economy and therefore tends to reduce private savings.

The literature has estimated that a 10 percentage points increase in the old-age dependency ratio could reduce the savings rate by around 9%. Simulation exercises based on models that assume that households behave as predicted in the life-cycle theory have found that the private savings rate in the European economies could fall from 15.9% of GDP in 1990 to around 4.5% by 2060

Impact on public finances: Well this is where problem is going to be severe as you would have more number of people asking for pensions and fewer contributing to it. And with old age people increasing, demand for healthcare also increases. This would put strain on public finances.

In the absence of significant reforms in pension systems, the Economic Policy Committee’s Ageing Working Group estimates that the costs related to old-age pension schemes will push government expenditure up by 2.6% of GDP in the euro area by 2050.Quantitatively, public healthcare costs are projected to increase by between 1% and 4% of GDP over the period 2000-2035, exacerbating the fiscal imbalances just discussed.

Impact on Investments:

The productivity of physical capital is typically influenced by two main factors: technological progress and the capital intensity of the production process. While it is not straightforward to identify clear links between ageing and technological progress, the literature has explored how demographic developments could affect capital intensity. The degree of capital intensity in the economy depends on the relative abundance of the different productive factors: the capital stock and the labour force. All other things being equal, ageing would presumably generate a fall in the rate of growth of the labour force, if not a contraction in its size. The production process would therefore become more capital intensive and the relative productivity of new capital purchases would be lower.Consequently, investment rates are expected to decelerate, and the growth rate of capital stock could gradually decline to better accommodate the relatively scarcer labour force.

Impact on interest rates: It would depend on whether the impact of savings or impact of investments is greater. As both are expected to decline, it would matter which happens first and faster.

If investment decelerates or falls faster than domestic savings – at each level of aggregate income – the real interest rate that clears the market for loanable funds is expected to fall, since it is difficult for savers to find profitable investment opportunities. Alternatively, if domestic savings were to fall faster than investment, the real interest rate would rise to reflect the relative scarcity of financial funds.What about the evidence available on the same?

Although the savings rate is expected to fall, the quicker projected drop in investment could push the equilibrium real rate down by around 50 to 100 basis points over the period 1990-2030, followed by a partial recovery by 2060 as the baby-boom effect disappears.

Impact on Fin Markets: As fin markets are forward looking do they see the above changes?

Some economists have suggested that expectations of such developments may have already started to exert some influence on the pricing of bonds. Among other things, these analyses suggest that ageing could have contributed to the “flattening” of the yield curve that has been observed over the recent past.But then there are many factors for the same and one should be careful in stating the same.

International Mobility:Immigration from developing countries could mitigate the above effects but looks remote as immigration laws are pretty stiff especially in Europe.

Impact on Mon Policy: Ageing Populations would depend more on wealth for their consumption needs and higher inflation might lead to lower real value of assets. Hence mon pol would have to be even more committed to fighting inflation.

It is an excellent speech from Trichet and sums up most of the research on the subject. It has a rich reference list as well. Highly recommended.

3. WSJ points Mark Carney, is the new governor of the Bank of Canada. He is just 42 years old. It also pointsto a new speech from Richard Fischer (Dallas Fed Prez) on benefits of trimmed inflation. Its assorted links also are quite good.

4. Mankiw also has similar feelings as I do, over Acemoglu. He also points to a profile of Goolsbee, Barack Obama’s eco advisor.

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Fed Governor Mishkin has recently given a speech on this subject at Chicago Fed.

The basic idea behind lender of last resort (LORL) is that when suddenly financial markets freeze due to some event and it becomes a systemic problem, the government/central bank should intervene and provide liquidity, hence called the LORL. This is also one of the very important functions of a central bank.

To be clear, by lender of last resort, I mean short-term lending on good collateral to sound institutions, when financial markets temporarily seize up. I do not mean rescuing financial market participants from the consequences of their bad decisions by lending to unsound institutions with little capital, thereby postponing the recognition of insolvency.

Mishkin says in mature economies central banks have to provide liquidity in domestic currency but in emerging markets it makes more sense to provide liquidity in foreign currency.

First, emerging-market economies often have much of their debt denominated in foreign currency. Second, the credibility of central banks in these countries to keep inflation under control is low. Accordingly, an injection of liquidity in the form of domestic currency can actually make the financial crisis worse by raising inflation fears and thus causing the domestic currency to depreciate.

Given a debt structure characterized by liabilities denominated in foreign currency, this depreciation causes the domestic-currency value of the liabilities to rise, induces a deterioration of balance sheets, and thus causes a severe economic contraction. Moreover, a run on the domestic currency will likely be associated with a spike in nominal domestic-currency interest rates–just the opposite of what the injection of liquidity was intended to achieve–which will further damage economic prospects.

What if the Central Bank does not have adequate foreign currency reserve?

But, if a domestic central bank lacks the foreign reserves to conduct emergency liquidity assistance in foreign currency to stop a financial crisis or promote a recovery when one occurs, can another institution come to the rescue? The answer is yes, and it is often best if the assistance comes not from within the country, but from without. Liquidity provided by foreign sources can help emerging-market countries cope with financial crises without many of the undesirable consequences that can result from the provision of domestic-currency liquidity by the domestic central bank.

How should LORL function?

Restore Confidence in the Financial System by Quickly Providing Liquidity

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This is one of the hot topics being discussed all around the world (others are sub-prime, global imbalances, sovereign wealth funds etc).

For a recent summary of the capital inflows read chapter 3of IMF’s recent global financial stability report. It has some good summary of how each country has responded to the increasing capital flows. The idea is the same – improve domestic financial systems so that they could absorb capital flows.

I have read number of papers and explanations on the relation between rising capital inflows and forex reserves but this one by Joshua Aizenman is quite good.

The general idea is that these countries are shoring upon their reserves to safeguard themselves from future crisis. He says:

While not a panacea, international reserves help by providing self insurance against sudden stops; mitigating REER effects of TOT shocks; smoothing overtime the adjustment to shocks by allowing more persistent current account patterns; and possibly even export promotion, though this mercantilist use of reserves remains debatable due to possible coordination issues. Countries following an export oriented growth strategy may end up with competitive hoarding, akin to competitive devaluations. The sheer size of China, and its lower sterilization costs suggests that China may be the winner of a hoarding game. Hoarding international reserves may also be motivated by a desire to deal with vulnerability to internal and external instability, which is magnified by exposure of the banking system to non performing loans. Testing the self insurance and precautionary motives in the context of China may be challenged by a version of the ‘peso problem.’ Hoarding international reserves and sterilization have been complementing each other during the last ten years, as developing countries have increased the intensity of both margins.

It has lots of insights on rising forex reserves in asian economies. Read on.

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I had posteda while ago on IMF’s recent report on Global Financial Markets. I just read this chapter on risk management techniques.

It is a pretty useful primer on risk management, Value at Risk in particular. It asks a basic question- DO risk management techniques (VAR) amplify risk?

Well as usual, it is a typical economist answer- not really. Risk management system do show that firms take on more risk when times are good and reverse it when times are bad. This leads to everybody becoming risk sensitive when bad times strike furthering the crisis (like what has happened in subprime crisis.) But still, the risk management techniques have helped understand firm’s risk position and are improving by the day.